Interest Rates on the Move

We have arrived at a very critical moment in the history of our country
— and in your financial future.

The main reason: Interest rates are on the move again, with potentially
sweeping impacts on nearly everything that concerns your money.

So forgive me if I speak frankly, even bluntly. Also, please give
me some latitude in the assumptions I make about your situation. Even
if some — or many — of my assumptions are wrong, bear
with me.

First, here’s what’s happening:

Last week, for the first time in four years, the U.S. stock market
opened the New Year with a weekly decline — due primarily to
spreading worries about rising interest rates.

And late last year, in
their minutes that have just been released, the members of the
Federal Reserve’s Open Market Committee expressed some of the most
serious concerns I’ve seen in many years about the falling dollar,
rising energy costs and excessive risk-taking by investors —
all factors that imply higher interest rates.

Look. Rising interest rates do not impact strictly investors who use
debt. Nor does it impact just a few sectors of the economy. Quite
to the contrary. The rising tide of interest rates affects almost
everyone, sweeping through virtually all sectors and all regions at
approximately the same time.

Rising interest rates can drive down the price of your bonds and your
stocks. They can impact the value of your home, your commercial property,
even your annuities and insurance policies.

Never borrow a penny? OK. But rising interest rates can still mandate
significant changes in the way you save, invest, speculate, and do
business.

So if there ever was a time for you to understand the potential consequences
of interest rates, this is it. If you do, you should be better prepared
for what’s coming in the months ahead. If you don’t, you could get
caught flat-footed.

Are You Vulnerable?

Right now, although you may be better prepared for rising interest
rates than most people, I suspect that you may still be vulnerable
in at least some key areas.

Rising interest rates aren’t bad for everyone. If you’ve got money
to lend, and if you lend it mostly for the short term, you benefit
directly from rising interest rates. The higher the rates go, the
more you earn.

But how much of your total assets do you have in short-term cash-type
investments? Is it really a large enough percentage for this new era
of rising interest rates? No?

How much should it be? There’s no perfect allocation that’s right
for everyone. A lot depends, of course, on your personal situation.
But no matter where you are in life, I recommend that you keep a pretty
big chunk of your money in 3-month Treasury bills or money market
funds that invest exclusively in short-term Treasuries.

As interest rates go up, you promptly get the benefit of the higher
yields. And unlike longer term notes or bonds, as long as you can
wait the three months, there’s no chance of suffering a loss in principal.

Yes, I know. You’re tired of sitting around in T-bills, making just
a percent or two. You really need, say, 5% or so to stay ahead of
inflation and income taxes. And what you’d really like is the kind
of gains that only riskier investments can offer.

So go ahead. Allocate a small portion to riskier investments that
have the potential to deliver high double-digit gains. Just be sure
to cap your high-risk investments to, say, one-tenth of your portfolio.
And also make sure that, even if those investments bomb out entirely,
you will never lose a penny more than you invest. (That rules out
playing with futures contracts or investing with borrowed money.)

What’s wrong with allocating most of your portfolio to rolling the
dice? Simple: The world we live in — with runaway deficits plus
the twin threats of rising interest rates and a sinking dollar —
is ALREADY risky in itself. So why would you want to compound
that risk even further by choosing mostly investments that could get
killed in times like these?

Do you feel like you’re running out of time? Do you feel you have
the need to make more money more quickly? I understand. But suppose
you lose. Then what? Will you have time to recoup?

Even if you were relatively young and you did have plenty of time,
it still wouldn’t make sense to put a lot of money in riskier
investments in this environment.

Crowd or Minority?

Because of the fundamental shift we’re experiencing right now —
from falling interest rates to rising interest rates — I have
no doubt that we are at a critical turning point in the financial
history of this country.

And so I must ask you this vital question: Do you want to be a part
of the crowd that’s still stuck in the bygone era of low interest
rates? Or do you want to join the small minority that is adapting
to the new environment or higher interest rates?

Before you answer that question, take a look around you to see what
the majority of your relatives, friends, and neighbors are doing with
their money right now:

* If they’re investing, they’re probably putting more money in the
stock market now than at any time since 1999.

* Many are dramatically stepping up their investments in real estate.

* Quite a few have refinanced their home and put that money at risk
as well.

* They’re saving far, far less than their parents or grandparents
did, despite the fact that the economy and the stock market are far
less stable than in those days.

* They’re buying stuff like crazy — SUVs, appliances, second
homes, boats.

* Few, if any, have a substantial portion of their money in short-term
cash-type instruments.

In short, they’re NOT ready for rising interest rates. They’re still
living in the past. In fact, when you add it all up — the investing,
the spending, and the scarce savings — I think it’s safe to
say that there are more people taking more overall risk today
than ever before in history.

If you think about it, though, you’ll see it all fits together in
a logical pattern: For at least a generation, Americans have been
big spenders and poor savers. Now, on top of that, we’ve been through
one of the longest period with some of the lowest interest rates in
modern times.

Borrowing money has been dirt cheap. Saving money has yielded practically
zilch. So if most people were borrowing to the hilt and saving next
to nothing, they were just doing what comes naturally — adapting
to their environment. Now, though, that environment is changing radically,
but behavior is not.

Crying Wolf?

You say: “But Martin, you’ve been warning about rising interest rates
for two years. And so far, all we’ve seen is a meager rise in short-term
interest rates from 1% to 2 1/4%. Where’s the wolf?”

Yes. And I’ve also been crying wolf about the stock market, which
has stubbornly resisted any serious decline for the past couple of
years.

But do you want to risk turning a deaf ear to my cautionary words?
Do you really prefer to follow Wall Street and Washington down a path
that could lead to still more disasters like those that struck in
2000, 2001, and 2002?

What Wall Street Wants

Wall Street wants you to forget. Month by month, they want to see
the memory of those years fade away. Step by step, they want you to
shed your caution and put your money in investments that help THEM
make more.

Ask yourself: How much do they make in commissions and fees when you
keep more of your money in cash or equivalent? In contrast, look at
how much money they make when you buy stocks, broker-operated mutual
funds, fixed annuities, and whole life policies.

They want you to buy what they want to sell. And the longer you lock
up your money and/or the more risk you take … the more they earn
from your investment choices and transactions.

My view: They simply don’t understand — or want you to understand
— the power of rising interest rates.

They don’t tell you how utterly dependent America’s consumers and
businesses have become on borrowing.

They don’t tell you how the two largest industrial sectors in America
— housing and autos — have become so extremely vulnerable
to rising interest rates.

They don’t want you to know how key financial industries — banking,
mortgage brokers, and insurance — have literally dug themselves
into an interest-rate hole which will be difficult to escape without
serious damage.

When interest rates were low or falling, these sectors enjoyed the
profit feast of a lifetime. When interest rates rise, expect famine
…

Housing Boom

I trust you’ve seen this phenomenon with your own eyes — the
mad rush to refinance at lower and lower mortgage rates … the huge
outpouring of new money into home construction … the meteoric rise
of real estate investment trusts … and the resulting boom in housing
prices. Now, please consider these simple questions:

– Suppose the Federal Reserve had not slashed interest rates to 45-year
lows in recent years. Wouldn’t the wild housing boom have been much
tamer?

– Wouldn’t higher interest rates have naturally choked off the abundant
supply of easy credit?

– Wouldn’t the higher rates have discouraged the massive building
on spec that we’ve witnessed in recent years?

– Wouldn’t they have compelled most home buyers to put up more cash,
pay higher mortgage rates and buy less expensive homes?

Unless you have a very exceptional source of information or line of
reasoning, I am going to assume that you have answered “yes” or “of
course” to each of these questions. So now, ask yourself: What is
going to be the fate of the housing boom if the Fed raises interest
rates back to normal levels?

My final question: Do you want most of your wealth vulnerable to the
consequences?

Autos

I don’t think I have to tell you what has happened in this sector.
I’m going to assume you saw this boom time phenomenon with your own
eyes as well.

You saw how the Big Three automakers in Detroit virtually gave away
as much cheap money as they could — just so long as it helped
them sell more cars.

You saw the triple-zero deals — no money down, no interest,
and no payments for a year. You saw how the auto companies leapfrogged
each other, always seeking to offer an ever better financing deal.
Well, all that was driven by some of the lowest interest rates in
history.

Now, though, with interest rates coming back up, it’s going away.
In the auto malls and showrooms, you don’t see the same kind of triple-zero
deals any more. On the radio and TV, you don’t hear the same drumbeat
of free-financing ads. The climate is changing. Yet most people still
don’t get it.

Banking

You’d think that when interest rates go up, banks could naturally
charge higher loan rates and make more money.

But it doesn’t work that way. Banks and other financial institutions
— like mortgage companies — have been mostly borrowing
short-term money and loaning out longer term money. And guess what:
It’s the short-term interest rates that are going higher sooner and
more sharply.

Result: Banks, most of which have been getting virtually a free ride
for years, are going to have to go back to the real world of paying
a reasonable price for the money they borrow … or more.

Plus, there’s one more problem that few people talk about, and fewer
still understand. While interest rates were going down or staying
relatively low, America’s largest banks plowed head long into one
of the foggiest and potentially riskiest area of all: Derivatives.

What are derivatives? They’re mostly contracts between banks and other
institutions — private bets on the direction of interest rates
and other markets.

Why? The stated purpose is usually protection against risks —
hedges. But quite frequently, banks use the derivatives for outright
speculation. Consider these shocking facts revealed by the latest
study of the Comptroller of the Currency for the third quarter
of 2004:

* The total notional value of all derivatives controlled by U.S. banks
has just hit a new, all-time high of $84 TRILLION.

* 87% of these derivatives are related to interest rates, with a big
proportion vulnerable to rising rates, especially if the rise is sharp
and/or unexpected.

* 92% of the derivatives are over the counter. In other words, they
are customized, one-on-one contracts between two institutions, and
are NOT under the auspices of an established exchange.

* The banks’ revenues from derivatives has plunged 58% year-over-year.

* The revenue decline was largely due to losses in derivatives related
to interest rates. These fell by $1.5 billion to a net loss of $1.4
billion for the quarter.

This is an ominous sign. Interest rates have just begun to move and
already we’re seeing serious dislocations and disruptions in this
highly volatile area. Again I ask: What will happen when interest
rates are really on the move?

My advice: Don’t wait for the events to unfold. Anticipate the troubles
ahead and get most of your money to safety now.

Good luck and God bless!

Martin

Martin D. Weiss, Ph.D.
Editor, Safe Money Report
Chairman, Weiss Ratings, Inc.
martinonmonday@weissinc.com

Martin Weiss
and “Martin on Monday” are non-partisan. Third-party ads do not necessarily
represent their opinion and should not be interpreted as an endorsement.